What Is a Good Debt-to-Equity Ratio and Why It Matters | Fi.Money (2024)

The debt-to-equity ratio a.k.a. D/E ratio is one of the key financial metrics used by investors and analysts to evaluate the financial health of a company. If a company has a high D/E ratio, this means that it is high on debt as compared to equity. If you are wondering, “what is a good debt-to-equity ratio?” and “why does it matter?”, we have all the answers for you.

How is the D/E Ratio Calculated?

The formula used to calculate the D/E ratio is:

D/E ratio = Total debt of the company / total shareholder's equity

If company ABC has a total outstanding debt of ₹10 Lakhs while its total shareholder’s equity is ₹40 Lakhs, then the D/E ratio is 1/4 = 0.25. Is this debt-to-equity ratio good?

What if the situation was reversed and the debt was ₹40 Lakhs while the equity was only ₹10 Lakhs. Then the D/E ratio would be 4. So, what is the ideal debt-equity ratio?

What is a Good Debt-to-equity Ratio?

The first thing to note is that there is no fixed number that denotes how much debt-to-equity ratio is good for a company’s stock. There are several factors involved such as the industry or segment it operates in, the products or services it offers, global market trends, socio-economic and geo-political situation, etc. Having said that, most experts believe a D/E ratio between 1.5 to 2.5 shows the company is financially stable.

Taking the above examples, a D/E ratio of 0.25 is very good as it shows that the company is mostly funded by equity assets and has low obligations to repay. The second example though, where the D/E ratio is 4 shows the company is mostly financed by lenders, and may be a risky investment.

Why Do Investors Use the Debt-to-equity Ratio?

Investors and analysts use the D/E ratio to assess a company's risk profile and financial stability. Generally, a higher D/E ratio suggests higher financial risk. However, a higher D/E ratio can, at times, also indicate that a company is taking advantage of cheap debt financing to grow its operations, which can lead to higher profits. It is prudent to use the D/E ratio in the context of the industry and competition. Benchmarking is a valuable exercise that can help you gauge the company’s financial position in a more complete manner.

Drawbacks of the D/E Ratio

While the D/E ratio can serve as a measure of the financial leverage of a company and indicator of its solvency, it should not be used as the sole criterion for making your investment decision. This is because the debt-to-equity ratio varies across industries. For example, the transport sector is known to have a naturally higher debt-to-equity ratio than most other industries since there is a lot of initial loan that is borrowed to buy the fleet of vehicles.

Moreover, a D/E ratio does not convey the underlying circ*mstances of the company. For instance, a company may have a high D/E ratio indicating it has more debts currently. But, this does not necessarily mean the company is performing poorly. It is possible that the company has invested upfront in a major project or is heading towards a growth phase and needs to borrow the money to support it.

Conclusion

A smart investor is an informed investor. You can use the debt-to-equity ratio to assess a company’s financial performance, but it is important to understand the context, the other financial metrics of the company (like earnings, assets, liabilities, etc.), and use the industry-wide benchmark to compare with, and identify if the debt-to-equity ratio is good or not. Having done your research, you can go ahead and invest in Indian or even US stocks for more global exposure.

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Frequently Asked Questions

1. Is a debt-to-equity ratio below 1 good?

Yes, a D/E ratio below 1 shows that the company has more equity-backed financing and lesser debts in comparison. However, do not use the D/E ratio as a standalone metric to evaluate the company’s performance.

2. Is a debt ratio of 50% good?

Yes, a D/E ratio of 50% or 0.5 is very good. This means it is a low-debt business and the company’s equity is twice as high as its debts.

3. What is an acceptable debt-to-equity ratio?

The D/E ratio can vary as per the industry and various other factors that influence the company’s performance. However, it is generally agreed that a debt-to-equity ratio between 1.5 to 2.5 indicates a financially stable company with a low risk profile.